European commercial real estate: how far will prices fall?

Alarm bells have increasingly been sounded over the past few months about the health of the commercial real estate sector squeezed, as it is, between persistently high inflation, which is impacting property valuations, and higher interest rates which, in turn, are triggering an increase in the refinancing costs faced by real estate investment companies. On top of this, the weakening economic outlook is weighing down on rental growth and simultaneously increasing property vacancy rates.

The credit analysts at Natixis Corporate & Investment Banking (Natixis CIB)  have assessed the extent of the decline in commercial property prices and the impact this will have on real estate companies, banks, insurers, and the mortgage market in general. 

A decline in real-estate valuations... but few transactions

With a 60% year-on-year drop in transaction volumes in Q1-23, the decline in investment was the first sign of the trend reversal observed in the real-estate sector, especially in Europe.
At the same time, real-estate valuations began to decline in Q3-22 as a result of rising interest rates, bringing an end to a virtually uninterrupted run of growth since 2009. On average, prime commercial real estate is down 17% for offices and logistics, and down 12% for shopping centers, with significant variations depending on the location, the country, and within the same urban area.

It's important, however, to put this into some sort of perspective: in the absence of a sufficiently large number of transactions, we can only partially corroborate this decline in prices considering that the price differential between potential buyers and sellers remains too wide to confirm this downward trend. 

At what point will commercial real estate finally hit rock bottom?

To estimate how far European commercial real estate may decline between now and the end of 2024 as a result of rising interest rates, Natixis CIB’s analysts modelled asset values directly or, alternatively, prime yields.
According to their findings, office space – also impacted by the wider adoption of telecommuting – is expected to decline by an average of 20% to 30% vs. the levels noted at the end of H1-22. This average masks considerable diversity, however, depending on the quality of the assets and their geographical location. 
With an estimated 9%-20% decline in value, the shopping center segment is expected to be the most resilient in the current economic environment, as the correction in retail property values began long before the other segments with the advent of “retail bashing”* and the threat posed by e-commerce. Since 2018, asset values in Europe have already fallen by an average of 45%.

Logistics assets are expected to decrease by 13% to 23%, significantly impacted by the sharp slowdown in activity, with growth forecast at just 0.6% in Europe, the lowest recorded since 2013.

The downgrading of real estate investment company ratings has only just begun

Over the past eighteen months, four of the twenty-two real estate investment companies monitored by our analysts have had their ratings downgraded and/or their outlooks revised downward. This trend is expected to continue, with six companies considered to have a significant risk of a ratings downgrade. On a more positive note, none – with the exception of one Swedish company – is at risk of breaching its bank covenants.

Real estate investment companies are directly affected by a deterioration both in their leverage ratios, driven by the decline in the fair value of their assets, and in their coverage ratios, depressed by higher interest rates and the concomitant increase in their financial expenses. Office properties are likely to experience the largest decline (-12.5%), closely followed by the residential real estate (-9.8%). Retail properties, chiefly comprised of shopping centers, should continue to put up a more resilient performance in terms of fair value (-5.8%). 

Paradoxically, the -4.1% decline in warehousing assets seems to contradict our estimates of a downturn in the logistics real estate market. This is because the value correction has already been largely recorded in the real estate investment company holdings, and the segment is buoyed up by strong growth in the e-commerce segment.
It would seem that the refinancing of European real estate investment companies between now and the end of the year remains manageable considering the liquidity available and the debt buyback operations concluded in advance. The outlook for 2025 and 2026, however, would appear more problematic with bond maturities (excluding hybrid debt) standing in excess of €25 billion equivalent per year.

European banks need to increase their provisions

With 7% of their total outstandings directly exposed to commercial real estate, European banks are sensitive to a likely increase in loss rates on these assets. 

The loan-to-value (LTV) ratio is a useful metric for assessing vulnerability to real estate loans. A sharp rise in the LTV ratio increases potential losses not covered by the amount of collateral in the event of a borrower’s default, putting pressure on banks' capital and, ultimately, increasing the capital cushion requirements imposed by the regulator.
Our study shows that the banks have made the necessary efforts to reduce their LTV levels, which stood at about 49% in 2022, compared with 75% in 2010, although the situation varies widely from one country to the next. On the other hand, they will have to significantly increase their provisions to cope with potential losses in the short-to-medium term.

The solvency of European insurers is very solid

10% of the investment portfolios of European insurers (excluding UK insurers) are exposed to real estate. Based on disclosures by insurers, our analysts attempted to estimate the exposure of European insurers to commercial real estate, taking into account their exposure to physical real estate as well as their holdings in real estate investment trusts.

The solvency ratios of European insurers are very solid, with coverage ratios averaging more than 200%, enabling them to absorb any shocks to their commercial real estate exposures. This suggests that the expected downturn in commercial real estate valuations poses less of a solvency risk to the majority of insurers. A collapse in this market, however, is liable to jeopardize the solvency of smaller insurers.

Covered bondholders benefit from several protection mechanisms

Lastly, 25% of covered bond programs are backed by commercial and residential mortgages, with Pfandbriefe (a type of covered bond collateralized by long-term assets) being overexposed to commercial loans. It is estimated that the sensitivity of covered bond spreads to commercial loans currently stands at just 2 basis points.
Indeed, covered bondholders benefit from several protection mechanisms: conservative LTV ratios, high over-collateralization, active management of the cover pools (replacement of non-performing loans with performing loans) and, lastly, investors have recourse to both the cover pool and the assets of the sponsoring bank. 

^{* The shift in consumer preferences from physical stores to online retailing.}

This article is a summary of a more detailed report reserved for subscribers; the full report includes investment recommendations per country and per issuer.